3Pricing and Output

Decisions: Imperfectly Competitive Markets

Alternative Market Structures

• Classifying markets (by degree of competition)

– number of firms

– freedom of entry to industry

• free, restricted or blocked?

– nature of product

• homogeneous or differentiated?

– nature of demand curve

• degree of control the firm has over price

Alternative Market Structures

• The four market structures

– perfect competition

–monopoly

–monopolistic competition

– oligopoly

Features of the four market structures

Features of the four market structures

Features of the four market structures

Features of the four market structures

Features of the four market structures

Features of the four market structures

Alternative Market Structures

• The four market structures

– perfect competition

–monopoly

–monopolistic competition

– oligopoly

• Structure → conduct → performance

Monopoly

• Defining monopoly– importance of market power

• Barriers to entry– economies of scale

– economies of scope

– product differentiation and brand loyalty

– lower costs for an established firm

– ownership/control of key factors or outlets

– legal protection

–mergers and takeovers

Monopoly

• The monopolist's demand curve– downward sloping• the greater the market power, the less elastic the

demand curve

–MR below AR

-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

AR and MR curves for a monopolyQ

(units)

1234567

P =AR(£)8765432

ARAR

, MR

(£)

Quantity

-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Q(units)

1234567

P =AR(£)8765432

TR(£)

8141820201814

MR(£)

6420-2-4

MR

AR

, MR

(£)

Quantity

AR

AR and MR curves for a monopoly

Monopoly

• The monopolist's demand curve– downward sloping• the greater the market power, the less elastic the

demand curve

–MR below AR

• Equilibrium price and output– Equilibrium output, where MC = MR

Profit maximising under monopoly

MR

£

Q O

MC

Qm

Monopoly

• The monopolist's demand curve– downward sloping• the greater the market power, the less elastic the

demand curve

–MR below AR

• Equilibrium price and output– Equilibrium output, where MC = MR

– Equilibrium price, found from D curve

Profit maximising under monopoly

MR

£

Q O

MC

Qm

£

Q O

MC

AC

Qm

MR

AR

AC

AR

Profit maximising under monopoly

Monopoly

• The monopolist's demand curve– downward sloping

• the greater the market power, the less elastic the demand curve

– MR below AR

• Equilibrium price and output– Equilibrium output, where MC = MR

– Equilibrium price, found from D curve

• Profit– Measuring profit

£

Q O

MC

AC

Qm

MR

AR

AC

AR

Total profit

Profit maximising under monopoly

Monopoly

• The monopolist's demand curve– downward sloping

• the greater the market power, the less elastic the demand curve

– MR below AR

• Equilibrium price and output– Equilibrium output, where MC = MR

– Equilibrium price, found from D curve

• Profit– Measuring profit

– Supernormal profit can persist in long run

Monopoly

• Monopoly versus perfect competition– lower short-run output at a higher price

– supernormal profit not competed away

– costs under monopoly• lack of competition to drive down costs

• BUT possibility of substantial economies of scale

– innovation and new products• less incentive to innovate

• BUT greater possibility of innovation through investing ploughed-back profit

– competition for corporate control

AR = D

MC

MR

£

Q O Q1

P1

Monopoly

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

£

Q O

MC ( = supply under perfect competition)

Q1

MR

P1

P2

Q2

AR = D

Comparison withPerfect competition

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

Monopoly

• Monopoly versus perfect competition– lower short-run output at a higher price

– supernormal profit not competed away

Monopoly

• Monopoly versus perfect competition– lower short-run output at a higher price

– supernormal profit not competed away

– costs under monopoly• lack of competition to drive down costs

• BUT possibility of substantial economies of scale

Monopoly

• Monopoly versus perfect competition– lower short-run output at a higher price

– supernormal profit not competed away

– costs under monopoly• lack of competition to drive down costs

• BUT possibility of substantial economies of scale

– innovation and new products• less incentive to innovate

• BUT greater possibility of innovation through investing ploughed-back profit

Monopoly

• Monopoly versus perfect competition– lower short-run output at a higher price

– supernormal profit not competed away

– costs under monopoly• lack of competition to drive down costs

• BUT possibility of substantial economies of scale

– innovation and new products• less incentive to innovate

• BUT greater possibility of innovation through investing ploughed-back profit

– competition for corporate control

Oligopoly

• Key features of oligopoly

– barriers to entry

– interdependence of firms

• Competition versus collusion

• Collusive oligopoly

– cartels

• equilibrium of the industry

£

Q O

Industry D = AR

Profit-maximising cartel

£

Q O

Industry D = AR

Industry MC

Industry MR

Q1

P1

Profit-maximising cartel

Oligopoly

• Key features of oligopoly

– barriers to entry

– interdependence of firms

• Competition versus collusion

• Collusive oligopoly

– cartels

• equilibrium of the industry

• allocating and enforcing quotas

Oligopoly

• Collusive oligopoly (cont.)– tacit collusion

• price leadership

• rules of thumb

– factors favouring collusion• few firms which are open with each other

• similar cost structures

• similar products

• there is a dominant firm

• significant barriers to entry

• stable market conditions

• no government measures to curb collusion

Oligopoly

• The breakdown of collusion

• Non-collusive oligopoly: game theory– alternative strategies

• optimistic or cautious approach?

– simple dominant strategy games

Profits for firms A and B at different prices

£2.00 £1.80

£2.00

£1.80

X’s price

Y’s price

A B

C D

£10m each

£8m each£12m for Y£5m for X

£5m for Y£12m for X

Oligopoly

• The breakdown of collusion

• Non-collusive oligopoly: game theory– alternative strategies

• optimistic or cautious approach?

– simple dominant strategy games• Nash equilibrium

Profits for firms A and B at different prices

£2.00 £1.80

£2.00

£1.80

X’s price

Y’s price

A B

C D

£10m each

£8m each£12m for Y£5m for X

£5m for Y£12m for X

Oligopoly

• Non-collusive oligopoly: game theory– alternative strategies• optimistic or cautious approach?

– simple dominant strategy games• Nash equilibrium

• the prisoners’ dilemma

Oligopoly

• Non-collusive oligopoly: game theory– alternative strategies• optimistic or cautious approach?

– simple dominant strategy games• Nash equilibrium

• the prisoners’ dilemma

– more complex non-dominant strategy games

Oligopoly

• Non-collusive oligopoly: game theory– alternative strategies• optimistic or cautious approach?

– simple dominant strategy games• Nash equilibrium

• the prisoners’ dilemma

– more complex non-dominant strategy games

– the importance of threats and promises

Oligopoly

• Non-collusive oligopoly: game theory– alternative strategies• optimistic or cautious approach?

– simple dominant strategy games• Nash equilibrium

• the prisoners’ dilemma

– more complex non-dominant strategy games

– the importance of threats and promises• are threats seen by rivals as credible?

Oligopoly

• Non-collusive oligopoly: game theory– alternative strategies• optimistic or cautious approach?

– simple dominant strategy games• Nash equilibrium

• the prisoners’ dilemma

– more complex non-dominant strategy games

– the importance of threats and promises• are threats seen by rivals as credible?

– the importance of timing

Oligopoly

• Non-collusive oligopoly: game theory– alternative strategies• optimistic or cautious approach?

– simple dominant strategy games• Nash equilibrium

• the prisoners’ dilemma

– more complex non-dominant strategy games

– the importance of threats and promises• are threats seen by rivals as credible?

– the importance of timing• decision trees

Boeingdecides

500

seat

er

500 seater

500 seater

400 seater

400 seater

400 seater

A decision tree

Boeing –£10mAirbus –£10m

(1)

Boeing +£30mAirbus +£50m

(2)

Boeing +£50mAirbus +£30m

(3)

Boeing –£10mAirbus –£10m (4)

Airbusdecides

B2

Airbusdecides

B1

A

Oligopoly

• Non-collusive oligopoly: the kinked demand curve theory

– assumptions of the model

£

QO

P1

Q1

Current priceand quantity

give one pointon demand curve

Kinked demand for a firm under oligopoly

£

QO

P1

Q1

D

D

Kinked demand for a firm under oligopoly

Oligopoly

• Non-collusive oligopoly: the kinked demand curve theory

– assumptions of the model

– stable prices

£

QO

P1

Q1

MC2

MC1

MR

a

bD = AR

Stable price under conditions of a kinked demand curve

Oligopoly

• Non-collusive oligopoly: the kinked demand curve theory

– assumptions of the model

– stable prices

– limitations of the model

Oligopoly

• Non-collusive oligopoly: the kinked demand curve theory

– assumptions of the model

– stable prices

– limitations of the model

• Oligopoly and the consumer

Oligopoly

• Non-collusive oligopoly: the kinked demand curve theory

– assumptions of the model

– stable prices

– limitations of the model

• Oligopoly and the consumer

– advantages

Oligopoly

• Non-collusive oligopoly: the kinked demand curve theory

– assumptions of the model

– stable prices

– limitations of the model

• Oligopoly and the consumer

– advantages

– disadvantages

Oligopoly

• Non-collusive oligopoly: the kinked demand curve theory

– assumptions of the model

– stable prices

– limitations of the model

• Oligopoly and the consumer

– advantages

– disadvantages

– difficulties in drawing general conclusions

Alternative Aims to Profit Maximisation

• Alternative aims– separation of ownership and control

– the principal–agent problem

– managerial utility maximisation

– profit satisficing

• Sales revenue maximisation (short run)– equilibrium output and price

• comparisons with short-run profit maximising

• implications for advertising

£

Q O

AR

MC

MRQ1

P1

Sales revenue maximising price and output

Profit-maximisingprice and output

£

O

AR

P1

MC

Q1

MRQ2

P2

Sales revenuemaximising

price and output

Q

Sales revenue maximising price and output

Alternative Aims to Profit Maximisation

• Alternative aims– separation of ownership and control

– the principal–agent problem

– managerial utility maximisation

– profit satisficing

• Sales revenue maximisation (short run)– equilibrium output and price

• comparisons with short-run profit maximising

• implications for advertising

– implications for the consumer

Alternative Aims to Profit Maximisation

• Growth maximisation– measuring ‘growth’

– equilibrium for growth maximising firm?

• Multiple aims– satisficing and the setting of targets

• different stakeholders with different aims

• various possible targets

• potential conflicts between targets

– organisational slack• a way of reconciling conflicting aims?

• cutting slack with 'just-in-time' methods

Pricing in Practice

• Do firms know their costs and revenues?

– difficulties in identifying the profit-maximising price and output

– difficulties in predicting rivals’ behaviour

• Cost-based pricing

– the use of a profit mark-up on AC• choosing the level of output

• choosing the mark-up

Choosing the output and profit mark-up

O

AC

£

Q

D

P1

Q1

f

gP2

Q2

j

h

Pricing in Practice

• Do firms know their costs and revenues?

– difficulties in identifying the profit-maximising price and output

– difficulties in predicting rivals’ behaviour

• Cost-based pricing

– the use of a profit mark-up on AC• choosing the level of output

• choosing the mark-up

• equilibrium price and output?

Pricing in Practice

• Do firms know their costs and revenues?

– difficulties in identifying the profit-maximising price and output

– difficulties in predicting rivals’ behaviour

• Cost-based pricing

– the use of a profit mark-up on AC• choosing the level of output

• choosing the mark-up

• equilibrium price and output?

– variations in the mark-up

Pricing in Practice

• Price discrimination

– meaning of price discrimination

• charging different prices to different consumers for reasons unrelated to costs

• the prices depend on price elasticity of demand

Price discrimination

P

QO

P1

D

200

O

P1

D

P2

150 200

P

Q

Price discrimination

Pricing in Practice

• Price discrimination (cont.)

– conditions for price discrimination

• firm must be able to set its price

• markets must be separate

• demand elasticity must differ between markets

– advantages to the firm

• higher profits

• possibility of cross-subsidisation

• Pricing and the product life cycle

– the four stages

• launch

• growth

• maturity

• decline

– competition and pricing in each stage

Pricing in Practice

O

Sa

les

per

per

iod

Time

The stages in a product’s life cycle

The stages in a product’s life cycle

O (1)Launch

(2)Growth

(3)Maturity

(4)Decline

Sa

les

per

per

iod

Time

Product notbecomingobsolete

Productbecomingobsolete